Category: Case Studies

An emerging market technology company provides services via mobile phones. The entrepreneur is confident in an acquisition opportunity, but investors wanted an alternative liquidity provision because acquisition has been uncommon for African tech companies in the social sector. The deal includes a provision for the company to redeem investor-owned equity at investor discretion after 7 years, mirroring a traditional “liquidity event” payout.

Investors did not want to rely solely on an exit via sale or IPO. At the same time, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments. In addition, the founders believed that an equity investment would be more attractive to subsequent institutional capital.

Target IRR: > 15%

Investment type: Redeemable preferred equity

Company: The company supplies information content in emerging markets that is accessible from mobile phones and tablets. The company has revenue and initial signs of direct-to-consumer and channel uptake. There is no established market, however, for the product, and no history of M&A in the sector and region where the company operates.

Investor: The investor group is led by a foundation that invests in early stage emerging market companies. The lead investor seeks a reasonable return, with an emphasis on supporting high risk/high impact companies.

Key Innovation

Redemption exit option: Conventionally, redemption provisions are used as downside protection and with the expectation that they are likely to have little practical use. Here, investors believe that redemption is just as likely—if not more likely—than a traditional exit by sale or IPO. The deal is structured to provide an attractive financial return through redemption after 7 years in a transaction that resembles an acquisition from the investor’s perspective.

Key Terms

Valuation: Total raise of $500,000 at $2 million pre-money valuation.

Legal structure: The terms are structured to closely approximate standard U.S. “Seed” preferred equity investment model (except for the redemption provision, which is not standard in U.S. Seed Preferred model).

“Lump sum” redemption: Investors can elect to redeem all or a portion of their shares at any time after 7 years. The right to redeem is individual, rather than based on the affirmative election of a minimum percentage of shares as is often seen in redemption provisions.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 15% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Redemption payment: The Company may elect to pay the redemption consideration over a two-year period, but subject to 8% interest during that period.

Special Considerations

Tax Consideration: The redemption option raises a question of whether the instrument could be characterized as debt for tax purposes, but such re-characterization is unlikely given the minimum 7-year term and option to redeem only a portion of the shares. Furthermore, other deal-specific factors support equity characterization (e.g., otherwise “thin” capitalization). See “original issue discount” details for more detail on potential tax issues.

“Lump sum” redemption considerations: The big question with this type of “balloon” redemption provision is what happens if the company does not have adequate resources to redeem the stock at the time of the election date. A few notes on this point:

Investors should analyze the company’s projected cash flow and consider the likelihood that the company will be able to generate sufficient cash to redeem the stock.

Investors and company may need to work together to modify the redemption payout in order to balance the company’s and investor’s cash needs.

The company may have negotiating leverage in a scenario in which cash is constrained, depending on the governing laws for the company and investment agreement. For example, even with a mandatory redemption provision in the certificate of incorporation, Delaware law prohibits companies from redeeming stock if the redemption would leave the company insolvent.

The company and investors may also want to evaluate the ability to finance the redemption through debt or through a later stage equity investment.

A family office with an environmental mandate invested directly into an emerging market manufacturer, and plans to earn a return when the company redeems investor shares.

Neither investors nor founders believed that a sale or IPO was a viable option within 5-7 years from investment. In addition, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments.

Target IRR: 15% +

Deal type: Redeemable preferred equity

Company: The company manufactures various products using recycled materials. The company had been cash flow positive for more than two years at the time of the investment, but local capital was unavailable to invest in increasing production capacity. There is no history of M&A or IPO activity in the sector in which the company operates.

Investor: The investment was led by a family office that invests globally to optimize both financial return and social and environmental impact. The other investors consisted of a European foundation and two individuals. The investor group seeks a reasonable return given the risk profile of the investment, with a targeted floor of 15% per year over 5 years.

Key innovation

Redemption incentive when investors cannot elect for redemption: The investor group initially sought to structure a redemption right at the election of the investors. They learned, however, that the law of the country under which the company was organized prohibits redemptions at the election of the investors. As an alternative, they allowed investors to mandate profits be set aside for a “redemption fund,” which can only be used for redemption initiated by the company.

Key Terms

Financial terms: Total raise of $450,000 at $775,000 pre-money valuation.

Legal structure: The terms are structured to closely approximate standard U.S. “Seed” preferred equity investment model (except for the redemption provision, which is not standard in U.S. Seed Preferred model).

Redemption: The company has the right to initiate a redemption at its election after 5 years, but the redemption is only effective if accepted by the investors. The investors have the right to require the company to set aside a reserve fund out of profits to fund a redemption. The objective with the set aside is that the company will be motivated to redeem the shares because of the restriction on the use of funds.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 12% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Special Considerations

Tax considerations: The relatively short redemption period of 5 years would normally cause concern that the IRS might recharacterize this instrument as debt rather than equity. The risk here, however, is probably very low because the redemption option requires “exercise” by both parties. Other factors may weigh in favor of equity treatment as well (e.g., otherwise “thin” capitalization). The instrument most likely avoids the “original issue discount” rules as exempt “participating preferred stock”, due to its participation in dividends and liquidation proceeds.

Other considerations: This structure would be useful in any scenario in which legal rules prohibit investor-initiated redemption and in cases in which the investors would like to control the timing and amount of any reserve that is set aside to fund a redemption.

A foundation invested in an emerging market cacao supplier, using debt with repayment paid back as a share of free cash flow, until a repayment cap is met.

The investment was structured to help maintain founder control, as the founder viewed the company as a long-term enterprise with no logical buyer or other traditional “exit.” In addition, the parties wanted to: (1) maximize the company’s use of the investment to accelerate growth before repayment and (2) protect investor downside (through debt seniority) while share participation in upside (through conversion option and participation rights).

Target IRR: 15% +

Deal type: Subordinated Variable Payment Debt

Company: The company is a Central American supplier of cacao that assists local cacao farmers with financing and training, in addition to sourcing, processing (fermenting and drying), and exporting cacao to high-price markets. At the time of investment, the enterprise had over 2 years of operational history and had achieved revenue. The founders projected profitability after 3 years from the time of investment.

Investor: The investment was led by an impact-oriented foundation, whose mission is to use market-based solutions to eradicate extreme poverty. The investment targeted financial returns slightly below market rate.

Key innovation

Flexible repayment terms and cash flow-based royalty: The unique approach is reflected in the repayment terms, which provide:

a 2-year repayment holiday,

payments computed by reference to free cash flow (similar to operating profit), and

total payment of 2x issue price, anticipated in about 7 years, based on a mutually agreed upon business plan outlining the Company’s projected spending, revenue, and capital use.

Special considerations

Tax considerations: Characterization as debt: The original term sheet lacked a “hard” maturity date, which created an issue of whether the instrument may be characterized as equity rather than debt for tax purposes. As a result, a 10-year maturity was added with a Company agreement to use best efforts to complete repayment by year 7.

“Original issue discount” (OID): The instrument generates OID, primarily due to the variable payment structure but also as a result of the 2-year payment holiday. The OID on this debt instrument will likely require reporting using the “noncontingent bond method” under the OID rules.

Other considerations: Skill- and time-intensive investment: This investment required a higher-than-average skill/experience level of the investment team, largely due to (1) negotiation/determination of the business plan and (2) the tax and OID issues (see above). The investment team relied on substantial (pro bono) legal assistance to finalize the investment, although many of the complicated legal and tax issues addressed exist in other impact investment structures and are not unique to this investment.

Significant prior relationship: The Company and investors had (1) a high level of confidence in each other, (2) a significant alignment of financial and impact goals, and (3) a strong, positive relationship, all of which helped to overcome the legal and tax issues and reach agreement on the requisite business plan. On deals without an extensive relationship and history between the parties, it may be necessary to compute payments using a “top line” metric, such as gross sales (rather than free cash flow).

A Latin American company produces and distributes green household cleaning products. Investors have funded the company with a convertible loan that is repaid monthly through a percentage of revenues as opposed to fixed interest payments, allowing the company more flexibility for growth than with traditional debt.

The company had limited sales and marginal EBITDA, which made valuation challenging, so the investor designed a tailored senior convertible loan that would be paid back through an escalating percentage of sales.

Target IRR: 20-25%

Type of investment: Senior convertible loan to a non-US-based enterprise

Investor: An impact investment fund focused on supporting the early growth of social and environmental companies in Latin America. It invests in a wide range of sectors, such as education, sustainable consumer products, health, housing, organics and clean energy. It seeks to tailor its transaction structures to the needs of each portfolio company.

Company: A producer and distributor of 100% non-toxic and biodegradable household cleaning products. Company is generating revenues and is cash flow positive.

Key innovations

Revenue-based loan: The company’s total loan obligation is fixed, and repayments are determined as a share of revenue, escalating over time until the entire obligation is repaid.

Conversion option for investors, at investor discretion: The loan may convert into equity at a pre-determined multiple of trailing revenue or EBITDA, at the discretion of investors.

Key terms

Investment amount: The investment was broken down into two tranches: (1) US$300k immediately, and (2) US$150k after 12 months, contingent on reaching predefined operating and financial milestones.

Repayment timeline: The target term is 5 years, with an 18-month grace period for both principal and interest.

Revenue share rate and repayment cap: After the grace period, the company pays an initial 3% to a maximum of 9% of revenues (escalating over 3.5 years) until the investor receives a total of 2.3x its original investment.

Conversion option: Convertibility provision allows the investor to convert into equity at its own discretion and at a valuation equal to the higher of 1x TTM sales or 5x TTM EBITDA. At the time of conversion, the investor can only convert the balance of the total obligation still owed calculated at 2.3x the total loan provided, less any loan repayments made up to that date. Conversion is only allowed after an initial 18-month lock up period.

Governance: The investor assumes one Board seat and has veto right over a number of pre-defined “Major Decisions”, including new share issuance, new debt issuance, CAPEX and budget decisions.

Special considerations

Tax considerations: The local tax regime does not have any special treatment for flexible debt schedules, so not a concern for the issuer in this case. For a U.S. lender, “original issue discount” tax implications could be significant given the grace period, variable nature of payments, and lack of”original issue discount” reporting by the company.

More detailed deal rationale and context:

Company has to be close to profitable or already profitable, so that it can service debt at a % of revenue after about 12-18 months.

Margins need to be strong, if investors are to take up to 9% of revenues by year 5.

Company should not have significant prior debt.

Company should not expect to have a large need for additional equity/debt requirements during the term of the investment.

Structure appealed to investor over equity because it would allow the company to grow and thrive over the longer term without needing to be acquired in the short to medium term to provide a liquidity event, for two reasons: (1) It was not obvious that the company would appeal to a strategic buyer within the life of the fund, and (2) The investor was concerned that sale to a strategic buyer could compromise its mission.

The structure also appealed to the company because the founders liked its equity-like alignment of incentives (the faster the company grows, the higher the IRR for the investor), however they got to retain more ownership than they would have under an equity deal and the investor’s returns are capped.

Local business environment: local founders are often comfortable with the idea of building a company for the long-term, with potential generational succession plan. Therefore, the idea that they wouldn’t be acquired in the next 5-7 years was not off-putting.